Liability limits, or caps, are one of the most frequently negotiated terms in contracts. Whether you’re dealing with a widely used standard like the Cloud Service Agreement (CSA) or a bespoke contract that was written for a single deal, understanding how the limitation of liability works is crucial for vendors, customers, and other contract stakeholders.
What is a Liability Cap?
A liability cap specifies the maximum amount that one or more parties could be on the hook, or liable, for in the event that there’s a breach or related problem with the relationship under the contract. This cap, like a lot of contract terms, is fundamentally about the allocation of risks between the parties.
A cap can cover all kinds of damages or be specific to a narrow set. The size of the cap can vary widely based on the type of product or service and the relative leverage of the parties.
Three Types of Liability Caps
Contracts typically use one or more of these types of monetary caps to limit liability:
General Liability Cap
This is the default cap that applies to most situations under the contract unless specifically excluded. Think of it as the baseline protection. The most common structure is to set this cap at one times (1X) the contract’s annual fees. In that example, if your software costs $30,000 per year, your general liability cap would be $30,000.
Increased Liability Cap
Certain kinds of situations may warrant higher liability limits. These increased caps, sometimes called “super caps,” most commonly range up to 5X the annual contract value. Continuing our example from above with a $30,000 annual contract, that would translate to an increased cap of five times that amount, or $150,000.
The increased cap is often triggered by contract breaches related to privacy and confidentiality.
Unlimited Liability
The parties to a contract might agree that certain breaches or violations should be uncapped, or have no limit on liability. While these claims are technically “unlimited,” they can sometimes be subject to a limitation on the types of damages that may be awarded, often called a damages waiver.
A common trigger for an unlimited cap is when the damage is the result of a party’s gross negligence or willful misconduct. In addition, some jurisdictions have set categories of damages that cannot be limited as a matter of law.
How Limitation of Liability Is Structured
When defining liability caps in contracts, there are several common approaches:
- Fee-Based Multipliers: Expressed as a multiple of the fees under the contract, like 1X or 5X
- Fixed Amount: Expressed as a specific dollar amount, like $30,000 or $2 million
- Hybrid: The greater of a multiple and a fixed amount. This approach is particularly useful in usage-based contracts where the amount of fees might not be known at the time the contract is drafted.
Is limitation of liability the same as indemnification?
Limitation of liability and indemnification are both used to shift risk in a contract, but they use different mechanisms to do so. As mentioned above, a liability cap is about the maximum amount that one or both parties will have to pay the other party if they breach the agreement. Indemnification, on the other hand, is about one party promising to compensate the other for problems involving a third party. You can think of indemnification similarly to how people think about insurance. It usually requires a third party to be harmed, and it only covers a certain set of pre-defined situations.
A common indemnification in software contracts is for third party intellectual property claims. A customer might indemnify the vendor for intellectual property issues concerning the content that they upload into the product. Then, if the vendor is sued because there is, for example, copyrighted content hosted on their servers, then the customer is obligated to pay for the expenses of and damages for that lawsuit.
The other side of indemnification for third party IP claims is for a vendor to indemnify the customer for any intellectual property claims about the product itself. This became more prominent when large companies incorporated open source software into their products and services, and they offered indemnification as a way to mitigate concerns from customers about the potential IP risks. Today, that pattern is repeating itself with vendors providing IP indemnification for generative AI in their products.
Because indemnities generally cover harm to a third party caused by the other party to a contract, many companies request that indemnification obligations are expressly not subject to any limitation of liability. Others see indemnity as a risk-shifting mechanism in a very litigious society, and therefore use a super cap to control the risk taken on by an indemnity. In addition, depending on how the indemnity and limitation of liability are worded, indemnities may be deemed a contractual obligation not subject to a liability cap at all. As a result, it’s important to be clear if you want any limitation of liability—whether a general cap or increased cap—to apply to indemnification obligations.
What’s common for the limitation of liability clause?
Thousands of companies use the Common Paper platform to close their deals, and as a result we have unique insight into what’s market in commercial contracts. We periodically release contract benchmark reports with analyses and context, and here’s what’s most common for limitations of liability:
- Over 80% of sales contracts utilize only a general cap (no supercap or unlimited)
- Only 1% of contracts have unlimited liability, but it’s more common in enterprise deals
- By far, the most common general cap amount is 1X the annual fees paid or payable under the agreement
- Paid or payable is important, because that prevents a customer from influencing the liability cap by not paying their bill